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With US dollar Libor embedded in local benchmarks, users need a similar replacement

At a benchmarks conference in Hong Kong recently, an audience polling question threw up an interesting conundrum.

The question was, which of the following is most crucial to the transition from US dollar Libor to the secured overnight financing rate (SOFR) in Asia?

A third of respondents at the Bloomberg/ISDA benchmarks conference selected the development of a SOFR term structure as their choice, with local regulator guidance on the future of risk-free rates and the interbank lending rate following close behind.

While the sample size was small, the pedigree of the respondents – a mix of bankers, asset managers, lawyers and consultants – could very well be an accurate representation of the industry’s view in Asia-Pacific.

On first glance, the audience reaction raises questions on why the development of a term structure for the SOFR is so crucial for the Asia market. But a closer look at how some of the region’s rates are constructed reveals why the poll result isn’t exactly a shocker.

Three local interest rate benchmarks – Singapore’s Swap Offer Rate, the Thai baht Interest Rate Fixing and the Philippine Interbank Reference Rate – are backed out of foreign exchange forward prices against the US dollar. One of the main inputs to this calculation is US dollar Libor.

So if the rate ceases, it needs to replaced by a similarly forward-looking term rate to avoid big changes in the current value of contracts linked to the benchmarks.

A term version of SOFR has other benefits for the region’s markets. For instance, using the same forex forward-based methodology, it could also be used to generate term risk-free rate benchmarks in markets that currently lack them, such as Hong Kong. If that were to eventuate, investors and regulators in Asia will heave a sigh of relief given that official work on a term structure is still nascent.

It could also prove valuable to cross-currency swap users once other markets switch to risk-free rates such as SOFR.

The trouble is there is currently no forward-looking term version of SOFR available, hence the growing attention Asian market participants are placing on the issue.

The Alternative Reference Rate Committee, the industry-led group overseeing Libor transition in the US, has been vocal about its goal of seeing a term SOFR rate be produced by a private administrator. Another possibility is Ice Benchmark Administration’s Bank Yield Index, which tracks the yields investors are willing to lend on an unsecured basis to large dealers.

Polling participants and investors alike would be hoping the first piece of the puzzle falls in place quickly for a smooth transition.